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Chapter 7: Problem 8

Decision Trees B\&B has a new baby powder ready to market. If the firm goes directly to the market with the product, there is only a 55 percent chance of success. However, the firm can conduct customer segment research, which will take a year and cost \(\$ 1.8\) million. By going through research, B\&B will be able to better target potential customers and will increase the probability of success to 70 percent. If successful, the baby powder will bring a present value profit (at time of initial selling) of \(\$ 28\) million. If unsuccessful, the present value payoff is only \(\$ 4\) million. Should the firm conduct customer segment research or go directly to market? The appropriate discount rate is 15 percent.

Short Answer

Expert verified
The expected present value of conducting customer segment research (\$16.525 million) is greater than the expected present value of going directly to market (\$15.4 million). Therefore, B&B should conduct customer segment research before marketing their new baby powder.

Step by step solution

01

Calculating Expected Present Value - Going Directly to Market

First, let's calculate the expected present value (PV) for going directly to market without any customer segment research. The probability of success is 55%, which means there is a 45% probability of failure. We can find the expected PV using these probabilities and the given payoffs: Expected PV = (probability of success 脳 PV if successful) + (probability of failure 脳 PV if unsuccessful) Expected PV = (0.55 脳 \$28 million) + (0.45 脳 \$4 million) = \(\$15.4 million)
02

Calculating Expected Present Value - Conducting Customer Segment Research

Next, we're going to calculate the expected present value if the company conducts customer segment research. After the research, the probability of success increases to 70%, so the probability of failure is 30%. However, we have to take into account the \$1.8 million cost for conducting the research and the fact that it takes one year to complete. First, let's calculate the present value of the cost spent on research, discounted by the discount rate of 15%: PV_cost = \$1.8 million / (1 + 0.15) = \(\$1.565 million) Now, let's find the expected PV for this scenario: Expected PV = (probability of success 脳 PV if successful) + (probability of failure 脳 PV if unsuccessful) Expected PV = (0.7 脳 \$28 million) + (0.3 脳 \$4 million) = \(\$20.8 million) However, since the research takes one year, we need to discount the expected PV using the discount rate to find its present value: PV_research = \$20.8 million / (1 + 0.15) = \(\$18.09 million) Finally, we have to subtract the present value of the research cost: PV_research - PV_cost = \$18.09 million - \$1.565 million = \(\$16.525 million)
03

Comparing Expected Present Values

Now, we can compare the expected present values of the two strategies: 1. Going directly to market: \$15.4 million 2. Conducting customer segment research: \$16.525 million Since the expected present value of conducting customer segment research (\$16.525 million) is greater than the expected present value of going directly to market (\$15.4 million), B&B should conduct customer segment research before marketing their new baby powder.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Expected Present Value
The Expected Present Value (EPV) is a crucial financial metric that helps businesses decide on the best course of action by analyzing potential outcomes. It combines the possible financial returns from an investment with the likelihood of achieving those returns. EPV can be thought of as a weighted average of all potential outcomes, using probabilities as weights. The formula for calculating the EPV for a decision is:
  • EPV = (Probability of Success 脳 PV if Successful) + (Probability of Failure 脳 PV if Unsuccessful)
So, in the context of B&B's decision about their baby powder, this metric is used to determine whether to proceed directly to the market or to first conduct customer segment research. If going directly to market, the EPV is calculated using a 55% probability of success, resulting in an EPV of $15.4 million. For the scenario where customer research is conducted, the probability of success increases to 70%, and after accounting for research costs, the EPV becomes $16.525 million, suggesting this option is more financially attractive.
Probability of Success
Probability of success is a key factor in decision-making, representing the likelihood that a particular investment or project will yield positive results. This probability can significantly change the expected value of an investment. In B&B's case, initially, there is a 55% probability of successfully launching the baby powder if they opt to directly go to market. This reflects the chance of achieving the projected returns without additional insights from market research. However, by investing in customer segment research, B&B can enhance their strategic insights, thereby increasing the probability of success to 70%. This increase demonstrates the value of thorough research, as it aligns product offerings with customer needs, improving the chances of success and ultimately leading to a greater expected present value. Thus, understanding and accurately estimating this probability is crucial for evaluating different strategic options.
Customer Segment Research
Customer segment research involves gathering detailed insights about different groups of potential customers. It helps a company tailor its products or marketing strategies to better meet the needs of specific segments. This research can significantly impact the probability of success for a product by aligning it more closely with consumer preferences. For B&B's baby powder, conducting this research comes with a cost of $1.8 million and requires a year to complete. The benefit, however, is clear: it raises the probability of success from 55% to 70%. This increase justifies the expenditure and time by potentially enhancing product-market fit. Engaging in comprehensive customer segment research helps in creating a more effective and potentially lucrative marketing strategy, as shown in B&B's consideration of expected values.
Discount Rate
In financial analysis, the discount rate is used to determine the present value of future cash flows. It accounts for the time value of money, recognizing that funds available today are more valuable than the same amount in the future due to their potential earning capacity. For B&B's decision-making process, a 15% discount rate is applied to project future cash flows back to their present value. This rate helps calculate how much future revenues and costs are worth in today's terms. Applying this discount rate, B&B finds the present value of the research costs to be $1.565 million. Similarly, the expected present value of future profits, after research, gets discounted to $18.09 million before considering research costs. Understanding how to apply the discount rate is essential for evaluating long-term projects, as it aids in comparing the viability of different investment options by providing a clearer financial picture.

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Most popular questions from this chapter

Abandonment Decisions Allied Products, Inc., is considering a new product launch. The firm expects to have an annual operating cash flow of \(\$ 22\) million for the next 10 years. Allied Products uses a discount rate of 19 percent for new product launches. The initial investment is \(\$ 84\) million. Assume that the project has no salvage value at the end of its economic life. 1\. What is the NPV of the new product? 2\. After the first year, the project can be dismantled and sold for \(\$ \mathbf{3 0}\) million. If the estimates of remaining cash flows are revised based on the first year's experience, at what level of expected cash flows does it make sense to abandon the project?

Abandonment Value We are examining a new project. We expect to sell 9,000 units per year at \(\$ 50\) net cash flow apiece for the next 10 years. In other words, the annual operating cash flow is projected to be \(\$ 50 \times 9,000=\$ 450,000\). The relevant discount rate is 16 percent, and the initial investment required is \(\$ 1,900,000\). 1\. What is the base-case NPV? 2\. After the first year, the project can be dismantled and sold for \(\$ \mathbf{1 , 3 0 0 , 0 0 0}\). If expected sales are revised based on the first year's performance, when would it make sense to abandon the investment? In other words, at what level of expected sales would it make sense to abandon the project? 3\. Explain how the \(\$ 1,300,000\) abandonment value can be viewed as the opportunity cost of keeping the project in one year.

Option to Wait Hickock Mining is evaluating when to open a gold mine. The mine has 60,000 ounces of gold left that can be mined, and mining operations will produce 7,500 ounces per year. The required return on the gold mine is 12 percent, and it will cost \(\$ 14\) million to open the mine. When the mine is opened, the company will sign a contract that will guarantee the price of gold for the remaining life of the mine. If the mine is opened today, each ounce of gold will generate an aftertax cash flow of \(\$ \mathbf{4 5 0}\) per ounce. If the company waits one year, there is a 60 percent probability that the contract price will generate an aftertax cash flow of \(\$ 500\) per ounce and a 40 percent probability that the aftertax cash flow will be \(\$ 410\) per ounce. What is the value of the option to wait?

Financial Breakeven Niko has purchased a brand new machine to produce its High Flight line of shoes. The machine has an economic life of five years. The depreciation schedule for the machine is straight-line with no salvage value. The machine costs \(\$ 390,000\). The sales price per pair of shoes is \(\$ 60\), while the variable cost is \(\$ 14\). \(\$ 185,000\) of fixed costs per year are attributed to the machine. Assume that the corporate tax rate is 34 percent and the appropriate discount rate is 8 percent. What is the financial break- even point? INTERMEDIATE (Questions 11-25)

Financial Breakeven The Cornchopper Company is considering the purchase of a new harvester. Cornchopper has hired you to determine the break-even purchase price in terms of present value of the harvester. This break-even purchase price is the price at which the project's NPV is zero. Base your analysis on the following facts: \- The new harvester is not expected to affect revenues, but pretax operating expenses will be reduced by \(\$ 12,000\) per year for 10 years. \- The old harvester is now 5 years old, with 10 years of its scheduled life remaining. It was originally purchased for \(\$ 50,000\) and has been depreciated by the straight-line method. \- The old harvester can be sold for \(\$ 18,000\) today. \- The new harvester will be depreciated by the straight-line method over its 10-year life. \- The corporate tax rate is 34 percent. \- The firm's required rate of return is 15 percent. \- The initial investment, the proceeds from selling the old harvester, and any resulting tax effects occur immediately. \- All other cash flows occur at year-end. \- The market value of each harvester at the end of its economic life is zero.
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